Deutsche Bank on trial

Rhyme and reason

Germany’s highest court censures its biggest bank

THE verdict matters much more than the punishment. On March 22nd the Federal Court of Justice in Karlsruhe ordered Deutsche Bank to pay €541,074 ($768,942) damages, plus interest, for failing to advise a middle-size client on the true risk of a complex swap transaction. Hardly life-threatening for Germany's biggest bank, but sobering for the industry.

“Ille Papier-Service brings Deutsche Bank to its knees”, crowed the plaintiff, a small paper company based near Frankfurt, on its website. Ille had twice been on the wrong side of decisions in lower courts but this time the judges “understood the nature of the transaction”, said Jochen Weck of Rössner, the company's lawyers.

Ille's deal, one of hundreds of interest-rate swaps that Deutsche sold up and down the country between 2002 and 2006, involved a bet on the difference between two-year and ten-year Euribor interest rates. Deutsche's fixed-rate payments to the company were netted against Ille's payments to the bank, which were based on the interest-rate difference, spiced by a multiplier. If the interest-rate spread widened the company gained on the deal; if the spread narrowed, or turned negative, its losses grew exponentially and were theoretically unlimited.

The court ruled that Deutsche's health warnings to Ille were inadequate and played down the risk of loss. “If you are able to read the words of a poem, you haven't necessarily also understood its meaning,” mused Ulrich Wiechers, the presiding judge.

The court also held that there was a conflict of interest, since Deutsche was both advising the client and, in effect, betting against it. As a result, the judges added, the bank should have told the customer how much the deal was worth to Deutsche from day one. In Ille's case it was around 4% of the contract's notional principal, or €80,000, according to expert calculations. A lawyer for Deutsche Bank warned in February that disclosing such profits could unleash a second financial crisis, if clients felt they could challenge any complex deal that had lost them money. The judges clearly were not persuaded.

The federal court will give a fuller, written judgment in a few weeks. That may help the 24 other plaintiffs with similar cases pending to reach a settlement with Deutsche Bank, but it will not help the dozens of other disgruntled customers who missed a three-year deadline from the signing of contracts to file suit.

Shareholders seem relatively sanguine: Deutsche's shares closed 0.7% lower on the day of the ruling. A statement from Deutsche after the federal court's judgment said the amount at stake in the various relevant actions against the bank is “very limited”. The bank's recent annual report does not even list these cases among the legal proceedings it faces; Josef Ackermann, the chief executive, has never publicly discussed the bank's role in these cases.

The bigger question raised by this case and others like it—such as the charges brought against Goldman Sachs by the Securities and Exchange Commission last year for allegedly duping clients into buying structured mortgage-backed securities—is about the duty of care that banks owe to their customers, and the responsibility that clients bear for the choices they make. Goldman has since drawn up new standards of business, which make distinctions between professional investors and less sophisticated customers, such as municipalities, which require more hand-holding. Whether Deutsche sees a similar need to change is not yet clear.